Ready for restructure?

Private equity firms hunting for distressed assets since the onset of the liquidity crisis have thus far been disappointed. Looser covenants and debt repayment schedules with plenty of headroom negotiated at the height of the liquidity bubble have enabled most portfolio companies to avoid painful insolvency processes. Although the UK economy is suffering more than most, with sterling may recently hitting an historic low against the euro, recession fears are some way off. The story is different in the US, where a number of private equity-backed companies have recently filed for bankruptcy.

A lack of bankruptcy filings, while suggestive of a market currently coping with the changing economic conditions, should not induce any complacency. ‘Now is the time for private equity firms to engage a specialist restructuring team, not once problems start to emerge’ says Carl Hanson at Alix Partners. Andrew Busby, director at H.I.G European Capital Partners, agrees. ‘Engaging the right team, including professional advisers is key point number one in a turnaround situation.’

Slower growth and potential stagnation in some sectors is the new reality which private equity firms must recognise and, if necessary, take preemptive action. Refinancing to keep debtors and opportunistic debt investors at bay is no longer an option. ‘Where companies have had problems in the past they have been able to refinance themselves out of trouble,’ says Busby. ‘If a company was facing a covenant breach or needed new financing pre-summer last year the money was readily available,’ agrees Mark Dewar at FTI Consulting.

Operational to the fore

Although the lack of liquidity in the system is restricting the ability of companies to optimise capital structures, a lot of the talk at present about distressed assets is just that. ‘There is a fair amount of distress around but not in the volume many expected,’ says Dewar. Michael Fiddy, restructuring partner at DLA Piper, says that ‘everyone is talking about distressed assets but the opportunities haven’t arrived yet. It has not been a busy six months.’ Hanson agrees but stresses that ‘private equity firms are getting sweaty and the problems are there – they just haven’t come out to the distressed buyers yet.’ Plenty of anecdotal evidence and off-the-record conversations suggest that there are private equity-backed businesses out there which are off-plan and struggling.

The buzz-word which has come to the fore in private equity circles since the beginning of the liquidity crisis is ‘operational.’ Whilst private equity has always claimed to add-value through its operational skills and abilities, it hasn’t always been the rule, especially at the large and mega buyout end. Over the next year it will become clear which private equity firms were hiding behind growth generated through multiple arbitrage and/or leverage and passing it off as operational. For those without the in-house operational skills, casting pride aside, biting the bullet and calling in specialist help will be necessary. ‘Investment directors are not always keen to admit there could be a problem – it is not in the culture of private equity. This denial can create inertia,’ says Hanson. ‘The reality is that it was easy to make money out of leverage. The challenge now is ensuring the quality and the capability of management,’ says Bob Ward, head of corporate restructuring at Ernst & Young.

Repayment schedules

The years of cheap and easy-to-access credit saw debt to equity ratios soar, amortizing schedules pushed back and bullet repayments become the norm. All of this was predicated on the basis of a healthy macro-economic climate enduring for the term of these loans. Some businesses have paid off only a cursory amount of debt since the package was agreed or in some cases none at all. These businesses now find themselves staring at imminent debt repayment schedules. ‘Amortising schedules, covenant structures and interest rate ratchets on loans are all issues facing private equity-backed businesses over the next six to nine months,’ says Hanson. ‘Some businesses will be facing a bullet repayment in the second half of this year and owners will need to decide whether to run the business for cash or profit,’ affirms Ward.

Servicing debt in a slower growth environment will necessitate cutting back in other areas in order to boost working capital, which Ward believes some firms ‘are not as focused on as they could be. Companies should be asking how to take costs out of the business and reduce working capital locked up on the balance sheet.’ This will not be a universally solution, as not all companies will have the luxury of focusing on cash flow at the expense of EBITDA, especially if a debt to equity covenant breach is looming. Avoiding a covenant breach may require an owner to approach the lender and request a covenant waiver or reset a covenant. However, with banks also looking to optimise balance sheets, relying on a lender’s generosity of spirit is an “if all else fails” option. ‘Banks are enforcing their credit policies far more rigidly than previously,’ says Fiddy.

Taking costs out the business will necessitate difficult decisions and hands-on-management. ‘You have to attack the cost basis and take as much out as you can. This can mean hibernating or shutting down whole product lines. Boosting the top-line is a long-term measure and is more difficult in the current environment,’ says Dewar. Bringing in a new executive or replacing a whole management team may sometimes be the only way forward for a business to progress.

Distressed debt traders

‘You can’t afford to have a default. If hedge funds buy in you are faced with re-pricing the capital structure and losing a huge amount of value,’ cautions Joe Swanson, managing director at Houlihan Lokey. Seeing debt become distressed is the other factor which plays into restructuring calculations. Once a company begins to struggle this is reflected in the price at which its debt trades and presents openings for activist investors such as hedge funds. ‘Once a bond becomes impaired the bond often gets traded from the par investors such as pension funds and insurance companies, to hedge funds,’ says Swanson.

The situation soon spirals if debt which was once held by passive investors is moved onto activist investors with a different agenda and return expectations. If a struggling company becomes a failing company it may have little option but to issue a debt for equity swap as a last throw of the dice. This would allow an investor holding the impaired debt the opportunity to convert its notes and claim some equity upside. ‘Hedge funds are always searching for the pivot security, the point when the value of the asset runs out. These investors target the pivot security in order to get equity upside and are not inclined to sell,’ Swanson adds.

In order to avoid being at the mercy of activist investors with a stake in the equity, private equity firms may look to buy-back debt trading at a discount before the pivot security has been traded. ‘Private equity firms are finally starting to buy back debt. It is a great strategy to then convert it to equity,’ says Swanson. In a stroke a private equity firm can reduce its interest expenses, retire the debt at a fraction of the principal and avoid opening up the capital structure to the ‘loan to own’ investors. However, as Swanson warns, waiting until the pivot security has moved on from the par investors is a dangerous tactic - activist holders are disinclined to sell with an equity carrot within reach.

Find more equity

Although easy refinancings are off the table, companies looking to reconfigure the capital structure can still do so provided they have a ‘good story,’ suggests Hanson. ‘If you are willing to inject fresh capital or have an acquisition lined up this could be enough to get new bank financing. What you can’t do is refinance for the sake of it,’ he says. ‘If private equity houses want to they can put more money into portfolio businesses,’ says Ward. Permira recently agreed to pump £125m of equity into UK betting operator Gala Coral in return for a relaxation of its covenants, with £85m going towards debt repayments. This deal saw the lenders increase headroom on covenants to 10 to 15% above Gala Coral’s forecast ratios. The downside of course is lower returns. ‘There is a huge reluctance to put cash in as every extra penny is a dilution of return,’ reminds Hanson.

Not all of these measures will succeed. There are certain to be more distressed assets in the market place in nine months time as off-plan businesses fail to make it back on-plan. This should present specialist turnaround investors with a stable of opportunities. However, with banks reluctant to finance deals for healthy businesses, Hanson questions whether turnaround players will find lenders willing to back companies in greater distress. ‘Where will the funds find the debt funding? It is a difficult sell to ask a bank to back a company with poor incumbent management and weak cash-flow,’ he says.

‘The ability of a fund to underwrite the entire transaction is crucial for these deals,’ says Busby. ‘Subsequent to the deal you can then engage hedge funds, retail banks and asset-backed lenders in order to refinance the debt component of the transaction, which we have been doing,’ states Busby. The next few months will reveal if private equity firms have the operational skills and have taken the decisions which will shrink the market for specialist turnaround investors.

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